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The Case Against the Case Against Taxing Health Benefits

As is frequently the case, the economically optimal and politically optimal strategies diverge on how to pay for health care. I have argued that the high-income surtax, such as has been proposed in the House’s version of health care reform, is liable to meet less resistance than most other payment mechanisms (although surely it will meet some). I have further argued that there ought to be at least one or two additional tax brackets above the current maximum of about $350,000 — that a multimillionaire should be taxed at a higher rate than someone making “only” $360,000. The surtax would provide for that too.

However, this is not the economically optimal way to pay for health insurance. Changing the tax code in this way is not liable to resolve any inefficiencies (that is, generate any cost reduction), nor does it have anything in particular to do with health care itself. An alternative that would meet both those criteria would be to remove the preferential treatment for employer-provided benefits like health insurance, which almost certianly does distort the market and increases the cost of health care.

Many serious reform proposals include a removal of the benefits subsidy. However, such a move would undoubtedly be politically unpopular, and so Congress is likely to decide to finance health care through other means. I can live with this: ultimately there is just about no way that high-income earners are going to get through the next decade or two paying the 35 percent marginal tax rate that they’re paying now, and so at most this is pushing forward an inevitable future tax increase.

What I have less tolerance for, however, is arguments in favor of retaining the benefits tax exemption on what purport to be solid economic grounds. Such an example can be found in today’s Washington Post in this editorial from James Klein and John Sweeney, who are the presidents of the American Benefits Council and the AFL-CIO, respectively. Let me walk you through their editorial and explain why I find their reasoning specious.

With rising health costs burdening businesses and families alike, does anyone really believe that employers or workers lack incentive to hold down costs? The tax treatment of health benefits no more contributes to high health-care costs than the deduction for mortgage interest is responsible for housing costs. Clearly, both are affected by far more complex factors.

Is this really the argument that Klein and Sweeney want to be making? We’re now experiencing, obviously, a huge collapse in housing prices, which may be the principal factor behind the current recession. The tax subsidies given to homeownership, specifically including the mortgage interest exemption, are oftentimes attributed as a partial cause of the bubble.

The cost of health coverage varies enormously based on geographic region and the age and health status of those in an insured group. Were benefits to be taxed, these common variations would lead to highly inequitable results, with some workers being taxed while their co-workers in other areas — or those who are part of a group with a different demographic composition but who are receiving the exact same coverage — would not.

The cost of employer-sponsored health care programs actually do not vary that much from state to state — from a low of $3,549 per year in Hawaii to a high of $4,712 in Delaware. Those living in the states with the most expensive health coverage would be paying about an additional $150 in taxes each year relative to the average, and those in the cheapest states would be paying about $150 less. That’s just not that much of a distortion (although the disparities are magnified if you’re buying a plan to cover your entire family).

More to the point, regional variance in the cost of health care coverage is small relative to other expenses. $50,000 per year in Chicago goes as far as $97,601 per year in Manhattan or $39,642 per year in Topeka. I don’t see a lot of people arguing, say, that housing expenses should be exempted from taxation, something which would benefit those in Manhattan, New York much more than those in Manhattan, Kansas. People can choose, within reason, where they live, with cost of living (including taxation rates), quality of life, the availability of employment, and prevailing salaries all competing factors; the market does a pretty good job of sorting this all out.

The criticism that lower-paid workers with coverage get less value from the tax benefit than those in higher tax brackets is plain wrong. One of the great success stories of labor-management relations over the past several decades is that workers have negotiated for and received comprehensive coverage every bit as valuable as that extended to higher-income Americans. It is hard to think of a tax preference that is enjoyed more equitably across the income spectrum than the exclusion for employer-sponsored coverage. As a Commonwealth Fund report concludes, low-income households with employer coverage receive a larger tax break as a percentage of income than those in higher income households. And the related claim that the current tax exclusion favors those with coverage at the expense of those without — even if it were true — is completely inapplicable when everyone is covered — an essential goal of reform.

This is a potentially sounder argument, although other studies have reached different conclusions. However, it would be blunted by the fact that taxation of health benefits would almost certainly include a carve-out for low-, middle, and probably even upper-middle class workers. This is also a case of two wrongs making a right. Personally, I think the tax code should be made somewhat more progressive — and I also think that the benefits tax exemption is a market distortion. From a tax policy standpoint, the optimal solution would be to remove the benefits tax exemption and simultaneously to change (lower) federal income tax brackets such that the policy would be revenue-neutral, on average, for families making $250,000 per year or less. Of course, people with relatively more generous health care benefits would take more of a hit, but that is the whole point. I don’t see why someone making $40,000 cash per year with a $10,000/year health insurance policy should be paying less in taxes than someone making $45,000 cash and a $3,000/year health insurance policy.

A number of unintended consequences could result from taxing benefits. Removing the tax preference could well lead young workers to “opt out” of employer coverage, thereby destabilizing employer-sponsored “group” insurance. Moreover, a failure to adequately index the exclusion would lead to more and more Americans becoming subject to the tax over time — just as the alternative minimum tax now captures far more people than originally contemplated. Other health-related benefits such as dental, vision and supplemental policies for particularly high-cost conditions such as cancer, as well as popular medical flexible spending arrangements, might need to be purchased on an after-tax basis — effectively making them much more expensive.

The unintended consequence of which Klein and Sweeney speak — that poorly-designed policy could create imbalanced risk pools if individuals are free to choose between an employer-sponsored plan and a individually-purchased plan — is a problem with any serious attempt to reform health care and has nothing particularly to do with the taxation of employer-provided health benefits. Their argument about indexing, moreover, is odd: sure, if you didn’t index the exclusion properly, it might create unanticipated hardships for some people. The solution to that would seem to be, um, to index the exclusion properly.

While some argue for setting a limit on the tax exclusion, it bears noting that the entire exclusion equates to about 10 percent of the nation’s staggering $2.4 trillion annual bill for all health-care expenses. That confirms at least two irrefutable facts. First, the tax exclusion is not responsible for high health costs. Second, for an amount that is roughly equal to one-tenth of the country’s health tab, enlightened tax policy makes possible essential health-care coverage to more than 160 million Americans.

Ten percent of $2.4 trillion is $240 billion a year. That’s a lot of money: about five times the amount that would need to be raised annually to make the the Democrats’ health-care plans deficit-neutral.

Klein and Sweeney have also set up a classic strawman argument: nobody has said that the benefits tax exemption is entirely responsible for the high costs of health care. But there’s a near-consensus that it’s partially responsible. And occasionally these distortions will have grave consequences. I have argued, for instance, that the differential tax treatment of benefits was partially responsible for the collapse of General Motors.

I have no doubt that the employer-based health care system is great — if you’re one of the 160 million Americans that happens to work for an employer who provides health insurance. But if you work for yourself, work part time, work for certain small businesses, or are out of work, you may also be out of luck. Moreover, if you want to leave your job but would be unlikely to procure health insurance in the private market, you’re in a heck of a predicament — imagine the dilemma that someone who is diabetic or HIV+ or has a congenital heart defect might find themselves in if they wanted to start their own business or leave their jobs to pursue an advanced degree but would lose their health insurance in order to do so.

About 63 million Americans do not have health benefits through their jobs and are also not eligible for a government-run program like Medicaid. Of those, only about 18 million — less than 30 percent — have bought insurance in the private market. Now, some of the missing 45 million are illegal immigrants, and others are people who could afford health insurance but choose not to purchase it — I have no sympathy for either group. But others are people who can’t afford health care or who are ineligible because of a pre-existing condition. Those are the people who are getting screwed. And it does not suffice, by the way, to take the pseudo-libertarian point of view and say “that’s the free market and them’s the breaks”. The reason we have an employer-based health care system in the United States is because of government interference in the markets, principally in the form of wage and price controls implemented during the Roosevelt administration.

Unionized workers in traditional manufacturing industries and public-sector industries — basically, those represented by the AFL-CIO — tend to have great health insurance benefits. (This is less true of the service-sector workers represented by the SEIU, which is why they have tended to be much quieter about this issue). These benefits were achieved through a legacy of years or even decades of difficult collective bargaining negotiations. Although Republicans will complain about it, I have a lot of sympathy for approaches that would grandfather in benefits achieved through collective bargaining, as any Democratic plans that would remove the benefits tax exemption would probably do.

But Klein and Sweeney aren’t merely arguing for that; instead they seem to be championing the very system that has led to many of the problems that we find with health care today. Most of the policies that unions advocate are concomitant with the interests of working-class people as a whole. I think a lot of people — particularly people under 40 — tend to grossly underestimate the impact that unions still have in getting Democrats elected. This, however, is one of the exceptions. Klein and Sweeney are on the side of public opinion here, but not sound public policy.

Nate Silver founded and was the editor in chief of FiveThirtyEight.